Recap

During Week 68, we elaborated at a high level the below requirements to initiate Tokenization. These are :

1. A Blockchain - the infrastructure on which tokens are issued

2. A Reference Asset - with a mechanism to derive & assess the value of such an asset

3. Custody - Means to provide custody for the reference asset

4. Settlement - Redemption & settlement of the Token & Reference Asset

Then we introduced the below steps in Tokenization:

Step 1 - Asset Selection for Tokenization

Step 2 - Valuation of Asset

Step 3 - Custodian Selection

Step 4 - Token Creation

Step 5 - Token Issuance

Step 6 - Trading & Exchange of Tokens

Step 7 - Redemption of Tokens

Let us explore each of the above :

Step 1 - Asset Selection

Any asset which is expected to generate value to it's owners can be a potential candidate for tokenization. How is an asset expected to generate value? It can be in two ways :

1. By providing a constant stream of cash flows to it's owners or

2. By a consistent increase in it's capital value

Let us take real estate. For an owner of real estate assets,

1. They can expect a constant stream of rental income

2. If their property is in demand, it's value is expected to increase

An asset can be also intangible like art or music where tokens can be used to signify ownership or access to a service(s) or utility like music etc.

Photo by Jené Stephaniuk on Unsplash

The asset selected for tokenization must

1. Have Clear & Transferable Ownership that can be legally transferred through the token &

2. Be Suitable for Tokenization (e.g., assets of questionable ownership cannot be tokenized)

Step 2 - Asset Valuation

During week 67 on Securitization, we saw that there is a "Reference Asset" which the asset originator uses for securitization. These assets need to be valued to ensure full transparency with regard to the asset value for investors.

Similarly, in tokenization, the asset subject to tokenization has to be valued accurately as the value of the tokens issued against this asset is dependent on the asset value.

Hence, asset valuation has significant implications on token value & it is critical that this is done by an independent valuer to ensure transparency & credibility.

Step 3 - Custodian Selection

Tokenization process involves tokenizing a Real World Asset (RWA) which is situated outside the Blockchain ecosystem to it's digital representation on the Blockchain. Hence there has to be a proper linkage between the RWA & it's digital representation.

For example., assuming there are tokens issued against gold stored in vaults of a Financial Institution, it is important that the physical gold is stored safely & with adequate security to ensure that the value of the tokens issued against that gold is safe.

Photo by Scottsdale Mint on Unsplash

Hence, appointing a reliable & trusted custodian for the RWA is crucial to ensure proper integrity & security of the physical asset which in turn protects the value of the digital representation & ultimately the token holders.

Step 4 - Token Creation

This is by far the most critical step in tokenization. It is like issuing shares in a start up company. Before we go into token creation, let us understand the important considerations when issuing shares in a company for the first time or as a start up:

1. Type of Shares - There are different types of shares which can be issued - common shares, preferred shares etc. The difference between these types of shares is in

   a. Voting Rights &

   b. Claim on Assets

   Common shares typically offer voting rights & common shareholders have the last or residual claim on assets in case the company is liquidated. Preference shareholders have preferential claim on assets during liquidation of the company but no voting rights.

2. Shareholding Structure - It is important to plan the company's ownership structure by deciding on issuing & allocating equity shares to founders, employees, investors etc. It is also imperative to consider any future change in ownership structure due to new issuance of shares (e.g., dilution)

3. Legal & Regulatory compliance - The provisions of security laws, compliance regulations, tax implications etc need to be considered for the company & the investors.

4. Vesting Schedule - Implementation of vesting schedule for founders' shares to ensure that they enjoy the benefit from their shareholdings only after a minimum period of stay with the company.

Why does a company need to issue shares in the first place?

1. For funding - Start ups initially need capital to fund their day to day business requirements as well as future investments.

2. For managing the company - There are legal structures in place to manage any company (which is beyond the scope of our discussion here) but suffice it to say that the incentives in owning a share of the company aligns with the long term strategy & vision of the company.

A startup can raise capital through borrowings or other means. But a share aligns the investor with the long term vision of the company in that a long term investor is rewarded for holding that share through dividends or capital appreciation.

With the above in mind, let us understand the mechanics of Token economics or Tokenomics. Let us first define Tokenomics: (Source :here)

Tokenomics is the science of the token economy. It covers all aspects involving a coin's creation, management & removal from a network.

The Tokenomics of a project typically considers five key factors:

1. Minting - How does a project create tokens?

2. Utility - What are those tokens for?

3. Distribution - How are tokens allocated?

4. Vesting & Release - How are locked tokens released over time?

5. Token Burns - How are tokens taken out of circulation?

Let us now move to Token creation.